Two Books ...and the Financial and Economic Crisis
To the extent that these waves of optimism and pessimism -- heck why not call them animal spirits -- are a real world force, then this argues that self-regulation of the financial industry is not likely to be sufficient. It's not a prima facie case in support of government regulation (especially if regulation can be captured, a la Simon Johnson's regulatory capture view). But I think we should at least try to regulation and/or other means of slowing down the excess movements (financial taxes could in principle work this way, as in the Tobin tax).
Akerlof and Shiller conclude Chapter 11 thus:
...financial markets require regulation. And sometimes, when these regulations fail, because of all the feedbacks between financial markets and the real economy, there is also room for thoughtful, careful policies of financial insurance. Rededication to protecting the financial consumer must be one of our highest economic priorities.
In an emergency, as a backup, when we do get into a recession, there is a monetary and fiscal policy. But we know that there are limits to such policy and to its effectiveness. It is now time to redesign financial regulations to take account of the animal spirits that often drive the markets, to make the markets work more effectively, and to minimize the extent to which we will need after the fact bailouts to get us out of the hole.
See also the oped in yesterday's WSJ.
By the way, the authors of both books agree that the point is not to dispense with price theory. That point is made on page 2 of Akerlof-Shiller, and in a quote of one of the fathers of behavioral economics, Richard Thaler, regarding the Shanghai apartment market: "Maybe it's just supply and demand" (p. 286). Rather, the point is that we need to augment price theory with a more realistic depiction of human behavior if we are to avoid a repeat of the current situation.
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